Commercial banks are usually one of the least expensive providers of loan capital. Banks are most interested in financing firms that can show an ability to repay the loan. This usually means a company must have a strong positive cash flow or assets as collateral that can be easily liquidated. Factors such as the content of the business plan and experience of the management are also considered.
Payment terms are usually up to seven years for loans from commercial banks. Most debt is secured, although some unsecured lines may be available. Personal guarantees are generally required resulting in exposure of the borrower’s personal assets in the event of a business failure. Even if the business is formed as a corporation, the limited liability feature is superseded by a personal guarantee.
The interest rate on a loan is typically expressed as a percentage in excess of the prime rate. Prime is the rate the nation’s largest banks charge their best customers. The prime rate itself will vary according to economic conditions; it is primarily dependent on the rate the banks themselves are charged by the Federal Reserve to borrow money. The percentage over prime that a customer is charged is based on the banker’s perception of the risk taken by granting the loan.
Lending institutions have different policies towards risk. Some are inclined to follow relatively conservative lending practices; other engage in more creative banking practices. Banks borrow money elsewhere at a lower rate and lend it out at a higher rate; therefore, the commercial bank’s primary concern is a borrower’s ability to cover principal and interest repayments. Although bankers are interested in all financial aspects of a borrowing firm, hard assets provide their primary insurance if the business fails.
Commercial banks are among the largest sources of credit to small businesses. According to the SBA Office of Advocacy’s 1999 report on small business lending activities, commercial banks had $371 billion in small commercial and industrial loans outstanding as of June 1998. The number of small business loans made by commercial banks increased from $7.9 million in June 1997 to $9.2 million in June 1998, with almost all of the increase in the under $100,000 loan category.
Types of Loans
This category of credit is the most traditional and widely used among businesses. Listed below are the most common forms of business loans used by small businesses:
These are simply installment loans that are paid back at regular intervals over a specified length of time. These loans are granted for a specific purpose, such as startup costs or working capital. The term of the loan will depend on the use of the funds, but it can range from short term (less than one year) to long term (more than five years).
A demand note is a single-payment loan that is intended for very specific short-term needs. Although the contract will usually call for payment in full within 90 to 180 days, the lender can call for (or demand) repayment of the note at any time. You may be asked to make periodic interest payments during the life of the note.
Lines of Credit
A line of credit, like a credit card, establishes a credit limit and specific terms for repaying money that is borrowed. Lines of credit are easy to access and offer flexibility in managing the cash flow needs of a small business. Many small business owners establish a line of credit as a precaution, before they have a real need for the money. Lines of credit are usually linked to short-term assets such as accounts receivable, inventory, materials, etc.
Government Assisted Loans
There are several loan programs in which the government provides a guarantee of repayment for other small business lenders. Government-assisted small business loans are offered by federal agencies such as the Small Business Administration (SBA), the Economic Development Administration (EDA) and the Rural Economic and Community Development (previously known as the Farmers Home Administration or FHA), as well as by state and local agencies. Government-assisted loans, like bank loans, usually require that the small business owner have their own money invested in the business in order to share the risk with the lender.
How Banks Make Lending Decisions
A lender wants to be assured that your company can and will repay the loan as agreed, and that the loan will not saddle you with too much debt, which could cause financial problems for you. To get this assurance, the lender will evaluate your business plan to learn about you, your associates, your objectives, and your plans for the company.
The lender will be looking for the Five C’s of Credit:
Capital – How much of your own money do you have invested in the business? How much money do you have in reserve, in case of unexpected needs?
Collateral – What is the fair market value of the security that you are offering to guarantee repayment of the loan? Does it meet the classic criteria for good collateral: (a) ease of transfer of title, (b) low cost/no cost to maintain/service, (c) increasing in value, (d) a ready and liquid market.
Capacity to Repay – How much profit will your company generate? Will your cash flow provide you with enough money on a regular basis to cover the repayment of the loan? Are your projections for sales and profits realistic when compared to other firms in the same industry?
Conditions – What are the economic, demographic, and regulatory trends which impact your business? What terms can be negotiated to allow the bank to evaluate the risk/reward considerations?
Character – What is your track record, personal and professional, in managing finances and paying credit obligations? Who are the key managers in your business; do they have the experience and the ability to run this business successfully?
How Will Lenders Evaluate Your Proposal?
Lenders have rules and policies to follow in determining the risk and feasibility of your plan and evaluating your loan proposal. In addition to business and financial projections a lender will look for six important factors:
Equity – The lender expects the borrower(s) to have already invested from 10 to 30 percent of the loan amount. If your business has existed for less than three years, plan for 30 percent.
Collateral – Lenders require sufficient collateral to protect the loan. The items pledged to secure the loans are assets which reflect the following liquidity:
Certificate of deposit 100%
Real estate 75-80%
Stock (publicly traded) 75%
Accounts receivable 50-75%
Personal guarantees – All parties to the loan request must be willing to pledge guarantees. Personal guarantees state that the borrower(s) truly believe in their venture.
Good credit based on borrower’s credit report(s).
Ability to carry debt service – The cash flow projections normally reflect this.
A secondary source of repayment – Important especially in start-up venture (e.g., spouse has a full time position)